Unfair shares

After two years of relative stagnation in the renminbi-US dollar exchange rate, renminbi deposits exploded in Hong Kong last year, growing 402% from 2009 to a whopping US$47.9 billion by the end of the year. The growth was charged by the resumption of the currency’s appreciation and the announcement of a slew of initiatives to develop Hong Kong as an offshore center for renminbi-denominated products.

A chorus of foreign bankers and economists is now predicting the arrival of a new golden era for investors in Chinese currency assets, but as usual the financial community is drawing hope from relatively insignificant developments. History should serve as a warning: While China has been internationalizing its capital markets for nearly 20 years, the results are decidedly mixed.

 

The first attempt to bring foreigners into China’s capital markets dates back to late 1991, when Beijing allowed selected companies to issue shares to foreign investors. The so-called B-shares, traded on the local exchanges but denominated in US or Hong Kong dollars, offered foreign investors their first direct exposure to renminbi-based company revenues.

The popularity of B-shares was soon undermined when China Brilliance Auto listed on the New York Stock Exchange; shortly thereafter, Tsing­tao Brewery became the first mainland-domiciled company to launch Hong Kong-listed shares, known H-shares. Demand for H-shares and Chinese listings in New York was robust, and allowed some Chinese firms to raise 10 times more than they could in Shanghai or Shenzhen.

However, the H-share craze didn’t last long after the Hong Kong handover: Bankers quickly ran out of state-owned enterprises (SOEs) that could pass for productive and profitable companies.

The handover also saw the peak of the “Red Chip” craze. Any company incorporated overseas that could claim a potential injection of China-related assets enjoyed a corresponding inflation of its stock price.

The first Sino-foreign securities company was formed during this frenzy. China International Capital Corp (CICC) was a joint venture (JV) between China Construction Bank and Morgan Stanley. CICC was to become the leading Chinese securities underwriter with a near monopoly on mega-listings of “national champion” SOEs.

The venture was a huge financial success for Morgan Stanley, which recently sold out its stake for a reported US$1 billion out of an initial investment of US$35 million. But it did not accomplish what Morgan Stanley wanted – namely putting the firm in a dominant position in the Chinese IPO market. Since selling out of CICC, Morgan Stanley has announced another JV with a less prominent domestic partner, China Fortune.

And the CICC-Morgan Stanley JV remains anomalous. While a number of other foreign securities houses established JVs post 2000, none was able to attain the success of CICC. Every deal ended up being a “one-off” with no clear approval process defined for further projects.

 

The primary obstacle to foreign participation was protectionism by the regulator on behalf of domestic firms and the central government. Even the recently announced deals by Morgan Stanley and J.P. Morgan included the caveat that the new JVs will not be able to conduct secondary market brokerage business for five years. This was a similar restriction to the one that CICC faced in 1995 and illustrates how limited the reform of this sector has actually been.

Even so, most of the major players have remained patient. While BNP Paribas has called it quits, terminating its JV with Changjiang Securities after only three years, its competitors remain, hoping to benefit from steadily increasing transaction volumes.

Participation in the dual Hong Kong-Shanghai listings of state banks and other national champions has proved a bonanza for some foreign bankers and brokers. But it has never been easy. For a recent example, Agricultural Bank of China’s (ABC) listing saw the foreign bankers accepting reduced fees after ABC management disputed the original terms.

As investors became more familiar with Chinese companies, there was also a resumption of interest in the domestic A-share market, where equities were denominated in renminbi but could not be held by foreigners.

Investors began to lobby Beijing to implement a Qualified Foreign Institutional Investor (QFII) facility, similar to one used previously in Taiwan to open its stock markets. QFII came, but slowly. In May 2001, headlines announced that QFII was weeks away. In December 2002, the rules were announced. In July 2003 the first trade was completed.

Even this halting launch was still greeted with great enthusiasm by the financial sector. But so far the results have similarly fallen short of expectations. In eight years, only 100 institutions have been granted QFII status and allocated a measly combined US$19 billion investment quota. New QFII applicants are told that they can expect to make their first trade as much as three years after their initial application.

Nor can investors console themselves with fixed-income investments. The growth in the range and number of fixed income products ballooned during the past decade, yet the market remains underdeveloped. QFIIs are not allowed to participate. Foreign banks can access the interbank market but only to serve domestic businesses; they cannot offer access to offshore clients.

Foreigners have done slightly better in the fund management industry, which was created from scratch in 1998. Instead of being limited to 33% ownership of a JV for a securities firm, foreign fund managers were able to hold up to 49%.

Yet local houses continue to dominate. The largest 10 fund houses (which manage 47% of the industry’s assets) are all domestically owned. It seemed to some foreign houses that the primary reason they were allowed into the market was for technology and IP transfer. One house was asked to provide an entire replica of its global stock research database to the domestic JV. When asked why the entire research database of European and US companies was required to invest in Chinese A-shares, a vague answer about learning how to analyze companies was the only response.

Foreign banks have not fared much better than brokers or fund managers. Although banking was specifically covered under the WTO provisions, foreign banks still operate at a significant disadvantage to their local counterparts. Foreign banks were forced to incorporate locally in 2006 in order to provide the full range of renminbi-based services, but their market share continues to fall.

Foreign participation is even more limited within the futures markets. Rules governing QFII participation in the index futures market have been announced, but a year after trading commenced there is still minimal foreign involvement. There is no sign that Beijing is even considering allowing foreign capital to trade the commodity futures markets.

 

Today, investors are considering what to make of two programs. The first is the issuance of renminbi-denominated (“dim-sum”) bonds in Hong Kong. The second is a proposed program that would allow renminbi-denominated offshore deposits to be invested in the domestic interbank market through yet another new facility, the so-called “mini-QFII.” Mini-QFII would allow Chinese brokers in Hong Kong to provide investment products that can access mainland markets.

Judging from past experiences, investors should remain skeptical. New business and investment opportunities will indeed become available, but their scale and accessibility will be very limited. The ease of issuing “dim-sum” bonds is offset by the fact that the issuer still needs Beijing’s approval to remit and repatriate the bonds proceeds onshore for actual use.

As for Mini-QFII, acces
s to the domestic interbank market will certainly be controlled with a quota. Even a plan to launch renminbi-denominated IPOs seems of limited value since H-shares, based on renminbi-denominated cash flows, already provide such exposure.

Indeed, the history of the H-share market may serve as a predictor of how the new offshore facilities will price renminbi risk. While H-shares have been hugely successful in terms of issuance and trading, they in no way dictate valuations of Chinese SOEs. Nor do they enforce market discipline on management. This is a mechanism for pricing shares, not companies.

Today, dim-sum bonds are borrowing at rates 200 or 300 basis points cheaper than they would need to offer in the domestic market. What is this telling us? Are domestic A-shares too cheap or are interest rates in the mainland too high?

Neither. The Hong Kong market reflects the supply-demand dynamic for the pool of money in Hong Kong, and nothing more. H-shares remain the easiest and in some cases the only available investment channel for foreigners desperate for renminbi. The popularity of dim-sum bonds shows how little interest renminbi deposit holders are receiving at the bank, and how they will buy anything that pays more than deposit rates. The offshore markets aren’t providing any meaningful signals to the domestic markets or to policy makers.

 

Whatever is slowly evolving in Hong Kong, there is no indication that Beijing has any intention of loosening its control of how quickly money comes in or out of the country. An appreciating renminbi or a more flexible currency rate does not necessarily lead to more relaxed capital controls. As the past 20 years have shown, China has been able to roll out new financial products and investment avenues without making any significant concessions to foreigners.

What would be far more significant is a freeing up of the current QFII facility to allow much larger inflows and outflows. This could easily be done but still within a very controlled and regulated manner. India has been able to operate such a system for years. But so far there is no sign of such liberalization here.

The latest market developments are in fact consistent with past policies – by now, it should be clear that the central government does not consider significant foreign participation in its financial markets to be vital for the country’s success. For all the different products available to foreigners, the net role of foreign firms and capital in the Chinese markets remains minimal.

To those with the daunting task of running China, state-directed markets are appealing and have worked so far. The weakness of such a system may only become apparent in the coming years as China tries to rebalance its economy toward a more sustainable and efficient use of resources and capital.

Without better allocation and pricing of capital, that rebalancing is likely to fail. Until Beijing realizes this, there’s not much for foreign investors in renminbi assets to get excited about.